Building the right emergency fund

One of the first pieces of financial advice given to young folks starting their career is that they should build an emergency fund. That’s good advice, given that emergencies can deliver big setbacks to one’s finances, if one is forced to turn to credit card debt or personal loans.

But how large should that emergency fund be and where should it be invested? Recent experience of real-life emergencies suggests that this is where generic advice tends to trip up.

Needed, a buffer

It is common practice to link the size of one’s emergency fund to one’s living expenses. So, if your family’s expenses on basics such as house rent, loan EMIs, groceries, food, health, school fees and so on work out to say, ₹40,000 a month, you are advised to hold an emergency fund equal to say, 6 to 9 month’s equivalent (₹2.4 lakh to ₹3.6 lakh).

The reasoning behind pegging the size of your emergency fund to monthly living expenses is that it should help your family tide over periods of income loss. If there’s a temporary interruption in your earning capacity due to quitting a job, getting fired or suffering an illness or accident, the emergency fund should take over during this period.

While this is logical, job losses or accidents are not the only events that can require large out-of-pocket spending and force you into debt. In recent times, families where multiple members were affected by COVID-19 incurred medical expenses running into lakhs of rupees that either completely eroded savings or led to high debt. During the Kerala and Chennai floods, folks had to vacate their homes at short notice and were forced to replace most or all of their household appliances damaged by floods, at one go. Emergency funds amounting to 6 or 9 months’ living expenses are clearly not built to handle such exigencies.

This is where insurance comes in, fetching you relatively high cover against a modest premium payment. While most young folks know that adequate health insurance covering dependents is essential, fewer know about household insurance and personal accident covers, both of which come at nominal premiums.

Insurance isn’t enough

Health and property insurance are essential components of preparing for emergencies. However, they do not do away with the need for an emergency fund. In natural calamities, accidents or medical emergencies, you need to prepare for the possibility that the event that put you through the wringer may be excluded from your insurance plan.

Most insurance contracts come with truckloads of fine print that include some kinds of emergencies, and leave out others. During COVID-19, many folks filing cashless hospital claims have found to their chagrin that they had to fork out large out-of-pocket expenses, because 40-50% of their hospital bills were disallowed by their insurer. Quite a few hospitals demanded upfront cash deposits to allot beds, over-charged on consumables such as PPE kits or billed more than government-approved rates for treatment that led to such partial reimbursement.

To guard against such exclusions, it would be best to build a buffer of say ₹1-2 lakh into your emergency fund, over and above your 6-9 months’ living expenses.

Cash component

Thanks to the rise of net banking and digital wallets, most of us can get by with very little hard cash in normal times. But in extraordinary times, currency often turns out to be the king. During the Chennai floods, most ATMs could not be operated as the machines simply didn’t receive cash refills. During COVID-19 times, we hear of hospitals demanding cash advances for quick admission and off-the-book purchases of hard-to-get medication.

An emergency fund lying in a bank FD or mutual fund may not meet all your needs in such cases. Though it is a sub-optimal choice from the point of view of safety and returns, it may best for you to hold some hard currency at home to tide over such situations. About a month’s living expenses should suffice.

Safety, not returns

Savings accounts, bank fixed deposits and liquid debt funds are the usual avenues that advisers recommend for investing your emergency money. But when making these selections, avoid the temptation to shoot for high returns.

Co-operative banks, small finance banks, new banks or banks with slightly shaky financials may offer higher interest rates on savings accounts and FDs to woo depositors. But, should they land in trouble, RBI can impose sudden moratoriums on withdrawals when you urgently need the money. The recent cases of PMC Bank and Yes Bank which saw withdrawals capped by RBI moratoriums are examples. For your emergency money, it is best to stick to systemically important banks despite uninspiring rates.

With liquid or debt funds, there’s even more reason not to be lured by returns. The crisis that the Franklin Templeton funds have run into, tell us that debt mutual funds with higher yields than peers are likely to be taking on both credit and liquidity risks. It is also best to go with conservative liquid funds that invest mainly in government paper.

Prioritise liquidity

The primary purpose of having an emergency fund is to be able to access the money at very short notice.

Take the case of liquid funds, a popular vehicle. The instant withdrawal facility on such funds is limited to ₹50,000. When you redeem higher sums, the official processing time is one or two business days. But the word ‘business’ is the operative word here. Should non-business days intervene, you may need to endure a 3- or even 4-day wait to get your hands on the money.

To avoid such delays, it may be best to divide up your emergency fund, to park some portion (say a third of it) in bank deposits with an instant online liquidation feature and a portion in liquid funds, while also holding hard currency that you can immediately access.